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Many mutual-fund managers travel far afield to find stocks for their portfolios. That's not the case for William Frels and Mark Henneman, co-managers of the
Mairs & Power Growth
Fund (ticker: MPGFX). Based in St. Paul, Minn., Frels, 73, and Henneman, 51, prefer companies in their home state, many in the Twin Cities, and the upper Midwest. As of Dec. 31, companies based in Minnesota accounted for 61% of their holdings. "You get one view from the CEO, and it is generally a positive one," says Henneman, of companies outside their bailiwick. He adds that living close to so many of the companies in which he invests allows him and his colleagues to get a broader perspective and a thicker Rolodex of contacts. Frels has been with the firm since 1992, and Henneman signed on in 2004. The $2.9 billion fund has had a consistently strong track record. Its 10-year annualized return of 10.21% bests the S&P 500 by 1.53 percentage points and places it in the top 8% of its Morningstar category. Morningstar named Frels and Henneman as their 2012 domestic stock-fund managers of the year, citing strong stock selection as one of their key strengths. Barron's spoke recently with the portfolio managers by phone.

Barron's:How do you define growth investing?

Henneman: The fund is called the Mairs & Power Growth, and that name comes from over 50 years ago, before the current definition of growth, value, and core. Morningstar puts us in the large-cap blend category, for instance. We are looking for companies that can grow. But we generally are looking for companies that aren't necessarily the high-growth, 20%-or-more growers.

By focusing on local stocks, Henneman (left) and Frels can keep better tabs on their issuers' prospects and performance.
Jonathan Chapman for Barron's

We also get called GARP, or growth at a reasonable price, very often, and we would agree with that. The valuation that we are willing to pay is highly dependent on what we expect the growth rate of a company to be. So the higher that rate, the higher the valuation. Every company is different in terms of the valuation that we are looking for. We use price to expected earnings, and we have a range of where we think a stock can trade. If it gets to the lower end of that range, it's likely to be on our buy list. If it gets to the higher end or above the higher end, it tends to be a stock that we'll trim.

Frels: As a rule of thumb, we don't like to pay more than twice the growth rate. So if you've got a 10% grower, we are somewhat reluctant to pay over 20 times earnings for that growth. Now, because of Fed policy and these very, very low interest rates today, most companies have a very high equity-risk premium. So things are distorted in this current environment, relative to historical experience, and one has to be careful how you use some of these historical or traditional benchmarks.

Henneman: First of all, Apple is not based in Minnesota. But we have discussed Apple, particularly since it was such an important force in the overall market. The main reason why we have shied away is because we believe the company's long-term competitive advantage in consumer electronics is just very difficult to maintain. We can look at companies through history that had what appeared to be a dominant position, only to lose it when the next hot product came out. We view the whole industry as being very difficult to invest in from a long-term perspective.

In the case of Apple, they had the iPod, but what were they going to have after that? And then, when they had the iPhone, what were they going to come up with after that? More recently, they came out with the iPad. So, clearly, we were wrong by not owning it through that period. But our view remains that it's extraordinarily difficult for Apple to maintain a long-term competitive advantage.

Henneman: Our long-term expected earnings growth rate on Target is 10%. One reason it is attractive now is that it had a disappointing Christmas season. The collaboration they did with Neiman Marcus was disappointing, at least from Target's standpoint, and Target's earnings have been depressed because they are spending heavily for their coming rollout of stores in Canada. So the valuation looks attractive. On top of that, earnings are a bit depressed. We don't view the Neiman Marcus issue as a problem at all. A retailer doesn't have great results on every program, and Target gained some valuation information from the Neiman Marcus venture.

What went wrong with the Neiman Marcus venture?

Henneman: The Neiman Marcus products were at higher prices and exceeded what Target's customers were willing to pay. But Target learned a lot about its customers. I'm sure it will use that to make further adjustments.

The consensus estimate for the fiscal year ending in January is $4.76 a share. The multiple is about 13 times. How does the valuation look?

Henneman: Well, we expect them to earn around $5 a share, excluding the dilution from the rollout of the Canadian stores. And we feel that their Canada rollout this year is going to go well and that it is underappreciated by the market. So it's a very reasonable valuation, relative to the market.

What gives you confidence about Target's Canadian foray?

Henneman: They are doing it all at once. Rather than slowly build out the network and the infrastructure that they need for this market, they are coming in all at once with excellent store locations in a market that already knows Target well. It is a very low-risk way of expanding to a new market.

Henneman and Frels' Picks

Company

Ticker

Recent Price

Target

TGT

$65.85

Medtronic

MDT

45.73

Donaldson

DCI

36.57

Ecolab

ECL

77.93

Source: Bloomberg

How well is Target managing the pressure on its margins?

Henneman: We don't expect a big increase in margins, but we think they are going to be able to hold margins, given the productivity gains that they got by just leveraging off their infrastructure. For example, the fresh-food business tends to be lower-margin, but it drives traffic nicely and maintains the overall model.

The stock was around $66 recently. What's your price target?

Henneman: The mid-$70s.

Let's move on to another holding.

Frels: MedtronicMDT 0.14052120592743997%Medtronic PLCU.S.: NYSEUSD78.39
0.110.14052120592743997%
/Date(1438376651342-0500)/
Volume (Delayed 15m)
:
4996463AFTER HOURSUSD78.39
%
Volume (Delayed 15m)
:
183831
P/E Ratio
29.25764192139738Market Cap
111027750274.444
Dividend Yield
1.9390228345452225% Rev. per Employee
220228More quote details and news »MDTinYour ValueYour ChangeShort position
[MDT] has been a disappointment, with the stock down 5% over the past five years, while the overall market is up about 18%. And the valuation has been continually eroded, more so than the fundamental progress of the company. In mid-2011, they brought in a new CEO, Omar Ishrak, from
General ElectricGE -0.07656967840735068%General Electric Co.U.S.: NYSEUSD26.1
-0.02-0.07656967840735068%
/Date(1438376405357-0500)/
Volume (Delayed 15m)
:
22490767AFTER HOURSUSD26.09
-0.01-0.038314176245210725%
Volume (Delayed 15m)
:
706739
P/E Ratio
581.2917594654789Market Cap
262981768687.412
Dividend Yield
3.524904214559387% Rev. per Employee
468803More quote details and news »GEinYour ValueYour ChangeShort position
[GE], and his major strategy has been to move Medtronic more into emerging markets, where the growth potential is greater. What you have here is arguably the world's best medical-technology company, selling at a discount to the market. This year, Medtronic's stock has moved up about 12%, compared with about 8% for the overall market. But the stock is still very reasonably priced for what we feel is quite an attractive earnings growth rate of close to 10%.

It trades at about 12 times the $3.69 a share we expect Medtronic to earn this year, and the market, depending upon your forecast, is around 14 times. So it is pretty close to a market multiple, yet we feel that Medtronic has the potential to deliver superior growth. After all, the U.S., Europe, Japan, and other countries have aging populations. And as those populations age, they require more health care and the type of products that Medtronic produces. So the company is pretty well positioned looking ahead, both here and abroad.

What about Obamacare's impact on Medtronic?

Frels: Medtronic has sold into Canada, Japan, and many European countries with nationalized health-care systems, and they have made good profits in those markets for many years.

The stock's at $46 and change. What is it worth?

Frels: Well into the $50s.

Will a particular niche or product drive growth?

Frels:As I said, many developed countries have aging populations. So that includes products for heart-rhythm controls, defibrillation, back problems, spinal problems, and diabetic problems. Those markets all have pretty strong growth potential. Currently, the company is benefiting a bit from recalls at rival
St. Jude MedicalSTJ -0.12176971992964417%St. Jude Medical Inc.U.S.: NYSEUSD73.82
-0.09-0.12176971992964417%
/Date(1438376590802-0500)/
Volume (Delayed 15m)
:
1774979AFTER HOURSUSD73.82
%
Volume (Delayed 15m)
:
72552
P/E Ratio
20.56267409470752Market Cap
20678606639.3671
Dividend Yield
1.5713898672446491% Rev. per Employee
347875More quote details and news »STJinYour ValueYour ChangeShort position
[STJ], which has had problems related to some of the leads used in installing pacemakers and defibrillators.

What other company looks promising to you?

Henneman:Donaldson DCI 0.41841004184100417%Donaldson Co. Inc.U.S.: NYSEUSD33.6
0.140.41841004184100417%
/Date(1438376534444-0500)/
Volume (Delayed 15m)
:
637504AFTER HOURSUSD33.6
%
Volume (Delayed 15m)
:
37120
P/E Ratio
19.649122807017545Market Cap
4568087854.07257
Dividend Yield
2.0238095238095237% Rev. per Employee
194375More quote details and news »DCIinYour ValueYour ChangeShort position
[DCI], a manufacturer of filtration systems based in Minneapolis. They sell to heavy-truck manufacturers;
CaterpillarCAT 0.3573707721761327%Caterpillar Inc.U.S.: NYSEUSD78.63
0.280.3573707721761327%
/Date(1438376411455-0500)/
Volume (Delayed 15m)
:
5122215AFTER HOURSUSD78.513
-0.117-0.14879816863792444%
Volume (Delayed 15m)
:
1081354
P/E Ratio
13.48713550600343Market Cap
47464524641.4808
Dividend Yield
3.917079994912883% Rev. per Employee
462318More quote details and news »CATinYour ValueYour ChangeShort position
[CAT] is a major customer. So that's actually the source of the weakness; heavy-truck manufacturing slowed a bit last year, and Donaldson had to cut its forecast for 2012. The stock was a pretty bad performer last year, down 4%, and so the valuation is attractive. We believe that the business will recover nicely. But the thing that is really attractive about that business is the air-filtration systems. They've got a technology that allows air-filtration systems to get smaller and smaller, with the use of nano-fibers. They created the filter, and all replacement filters are provided by Donaldson. They've built a huge competitive advantage.

The majority of their profitability is coming from the replacement market. And, of course, Caterpillar wants to use Donaldson's filters. They are manufactured by Donaldson, but they are sold in Caterpillar's dealerships under the Caterpillar name.

How will Donaldson fare in a sluggish U.S. economic environment?

Henneman:Things will be just fine, and frankly, that's just part of the story. International growth will continue to be stronger. The other part of their business is filtration for gas turbines. In the U.S., a big growth driver will be low natural-gas prices and abundant supplies of that fuel. New capacity that is coming on for generating electricity tends to be powered by natural gas. Donaldson provides filtration systems; it has a very nice market share, and it will maintain that share going forward. That's going to be a big growth driver for this company.

With the shares around $36 recently, they fetched about 21 times the $1.71 analysts expect the company to earn this year. That's not exactly cheap.

Henneman: It is never a classically cheap stock. But it meets our main bogey, which is that it trades at less than two times its growth rate. The reason this stock is generally more expensive is because they do have an exceptional return on capital—it had a return on common equity of 28.7% in its most recent fiscal year, for example—and I like how they really lock in their business by selling the replacements. We are very comfortable paying this multiple, given where the market multiple is and because of the strength of their business model. Our price target is $44.

Let's close with one more holding.

Frels:Ecolab's
ECL -0.24978466838931956%Ecolab Inc.U.S.: NYSEUSD115.81
-0.29-0.24978466838931956%
/Date(1438376428653-0500)/
Volume (Delayed 15m)
:
893079AFTER HOURSUSD115.81
%
Volume (Delayed 15m)
:
29926
P/E Ratio
28.52463054187192Market Cap
34483699099.7046
Dividend Yield
1.139797944909766% Rev. per Employee
299200More quote details and news »ECLinYour ValueYour ChangeShort position
[ECL] major area is cleaning compounds, sold primarily to restaurants, hotels, and the hospitality industry worldwide. They are located right down the street from where we are, so we have had the CEO, Douglas Baker, in here on any number of occasions. Recently, they made a major acquisition that gets them into some new markets. At the end of 2011, Ecolab merged with Nalco of Chicago [in a deal valued at about $8.3 billion]. Nalco is in water-filtration and water quality, and the deal gets Ecolab into some industrial and commercial markets that they really didn't have much penetration in. So far, the merger of two relatively large companies has gone quite smoothly, and they've been able to generate the kind of savings that they were projecting. But the stock isn't cheap.

By our calculations, Ecolab trades at about 22 times this year's profit estimate of $3.48 a share.

Frels: It's always sold at a pretty good premium to the market, mainly because of its above-average growth and ability, at least in the past, to deliver in more difficult economic environments. The price/earnings ratio probably isn't going to improve much. But this merger will give Ecolab continuing earnings-growth momentum.

What about a price target? It was at $77 recently.

Frels: It's not on our Buy list currently, because it has had pretty good performance over the past year. So far this year, it's about even with the market, up 5%. But we feel very confident about Ecolab's ability to continue to deliver above-average earnings. The stock can get to the mid-$80s.